Interest-only buys cash yield and cover today with a bigger balloon tomorrow. The arithmetic shows exactly how much of each, and which party the trade really helps.
An interest-only loan pays only interest, so the balance never falls; an amortising loan adds a slice of principal to every payment. On an illustrative 19,500,000 loan at 6.25 per cent, interest-only costs 1,218,750 a year against 1,440,778 on a 30-year schedule, lifting cover from 1.25x to 1.48x. The price is a balloon that is 3,073,646 larger after ten years, while the equity IRR gains only 0.17 of a point.
Worked in full in Real Estate Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A fictional stabilised property bought with a ten-year loan. Three structures are compared: interest-only for the full term, three years interest-only then amortising, and amortising from day one. All figures are illustrative, not market terms.
| Input | Value |
|---|---|
| Price | 30,000,000 |
| Year 1 NOI (6.00% cap rate), growth a year | 1,800,000, 2.0% |
| Loan (65% LTV) | 19,500,000 |
| Equity | 10,500,000 |
| Rate, fixed, monthly payments | 6.25% |
| Amortisation schedule, term | 30 years, 10 years |
| Exit cap at year 10, on year 11 NOI | 6.50% |
Interest-only = 19,500,000 × 6.25% = 1,218,750 a year
Amortising monthly payment = 120,065, Excel =PMT(6.25%/12, 360, -19500000); a year = 1,440,778
Loan constant = 1,440,778 / 19,500,000 = 7.39%, against 6.25% interest-only
The difference, 222,028 a year, is the cost of repaying principal: in year 1 the amortising loan actually repays 228,500, slightly more, because interest falls as the balance does. That principal is the equity's own money being returned to it through the loan.
| Measure | Interest-only | 3 years IO, then amortising | Amortising |
|---|---|---|---|
| Year 1 debt service | 1,218,750 | 1,218,750 | 1,440,778 |
| Year 1 DSCR | 1.48x | 1.48x | 1.25x |
| Year 4 DSCR | 1.57x | 1.33x | 1.33x |
| Year 1 cash yield on equity | 5.54% | 5.54% | 3.42% |
| Total interest, ten years | 12,187,500 | 11,798,248 | 11,334,137 |
| Principal repaid | 0 | 1,943,450 | 3,073,646 |
| Balance at maturity | 19,500,000 | 17,556,550 | 16,426,354 |
| Balance as % of loan | 100.0% | 90.0% | 84.2% |
| Equity IRR, ten years | 9.23% | 9.17% | 9.06% |
| Equity multiple | 2.07x | 2.11x | 2.16x |
The sale in all three cases: year 11 NOI of 2,194,190 at 6.50 per cent, 33,756,769. Less the balance, the equity receives 14,256,769 interest-only and 17,330,415 amortising.
Interest-only moves cash forward, not value. The investor collects 222,028 a year more in the early years and pays it back, with the interest saved, in a smaller sale cheque. The IRR moves from 9.06 to 9.23 per cent because the property's unlevered return, 7.38 per cent, is above the 6.25 per cent the debt costs: leaving principal in the loan is a small dose of extra leverage. Had the debt cost more than the property earns, interest-only would lower the IRR.
For the lender the trade is different. Amortisation repays 3,073,646, 15.8 per cent of the loan, before the refinancing test. Interest-only leaves the whole 19,500,000 hanging on the exit value: a value 10 per cent below the projected 33,756,769 at maturity, 30,381,092, takes the interest-only loan to 64.2 per cent and the amortising one to 54.1. On income the effect runs the other way: NOI can fall 32.3 per cent before interest-only cover drops to 1.00x, but only 20.0 per cent on the amortising schedule. Cover today and cover at maturity point in opposite directions.
| Rate | IO debt service | Amortising debt service | Principal share, year 1 | DSCR IO | DSCR amortising |
|---|---|---|---|---|---|
| 5.00% | 975,000 | 1,256,163 | 22.9% | 1.85x | 1.43x |
| 6.25% | 1,218,750 | 1,440,778 | 15.9% | 1.48x | 1.25x |
| 7.50% | 1,462,500 | 1,636,162 | 11.0% | 1.23x | 1.10x |
The higher the rate, the smaller the principal slice and the smaller the gap between the two structures. At 7.50 per cent even interest-only cover, 1.23x, falls just short of a 1.25x test. That is why borrowers ask for interest-only when rates are high: it is the structure that comes closest to sizing, and here even it fails.
The partial structure, three years interest-only then amortising, is the usual compromise, and the table shows what it buys. It keeps the 1.48x cover and the 5.54 per cent cash yield through the years when a value-add plan is still lifting income, then starts repaying once the NOI has grown: cover in year 4 is 1.33x, the same as the fully amortising loan. It leaves 17,556,550 to refinance, 90.0 per cent of the loan, and an equity IRR of 9.17 per cent. For a lender it is a bet that the business plan delivers before amortisation starts; for a borrower it is the cheapest way to buy three years of cash flow.
Interest-only also enlarges the loan a cover test allows. At 1.25x on 1,800,000 of NOI, interest-only supports 23,040,000, or 76.8 per cent of the price, against 19,489,467 amortising. A lender that sizes on DSCR alone and then grants interest-only has quietly moved from 65.0 to 76.8 per cent LTV, which is why serious term sheets pair the cover test with an LTV or debt yield test.
Comparing an interest-only DSCR with an amortising one as if they measured the same risk. 1.48x interest-only and 1.25x amortising are the same building and the same loan; the first simply excludes principal. Underwrite the refinancing on the balance the structure leaves, 19,500,000 or 16,426,354, and test cover on the next lender's amortising constant, as worked in how to calculate the mortgage constant.
The book's sizing chapter runs LTV, cover and debt yield together and shows which one binds; the live sheet is in the free workbook for this case.
Only slightly, when the property earns more than the loan costs. In the illustrative case interest-only lifts the equity IRR from 9.06 to 9.23 per cent over ten years, because the principal that amortisation would repay stays borrowed at 6.25 per cent while the property earns 7.38 per cent unlevered. The equity multiple falls, from 2.16x to 2.07x, because the larger balance pays 853,363 more interest over the ten years.
Because the balance does not fall, so the loan-to-value at maturity depends entirely on the value holding up. On the illustrative 19,500,000 loan, ten years of amortisation would repay 3,073,646, 15.8 per cent of the loan, a cushion an interest-only lender gives up. Many lenders allow interest-only only at lower LTVs or for a few initial years.
Divide NOI by the minimum cover and by the debt cost. With 1,800,000 of NOI and a 1.25x test, interest-only at 6.25 per cent supports 23,040,000, 76.8 per cent of a 30,000,000 value, against 19,489,467 on a 7.39 per cent amortising constant. A lender will normally cap the loan with an LTV or debt yield test as well.
This article is one calculation from Real Estate Finance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.